Financial Risk Management; Financial Decision Criteria

Risk

Risk refers to the probability of loss, Risk arises as a result of exposure.

Exposure to financial markets affects most organizations, either directly or indirectly. When
an organization has financial market exposure, there is a possibility of loss but also an
opportunity for gain or profit. Financial market exposure may provide strategic or
competitive benefits.
Risk is the likelihood of losses resulting from events such as changes in market
prices. Events with a low probability of occurring, but that may result in a high loss, are
particularly troublesome because they are often not anticipated. Put another way, risk is
the probable variability of returns.

Potential Size of Loss Probability of Loss

Potential for Large Loss High Probability o

Occurrence
Potential for Small Loss Low Probability o
Occurrence

How Does Financial Risk Arise?

Financial risk arises through countless transactions of a financial nature, including sales
and purchases, investments and loans, and various other business activities. It can arise as
a result of legal transactions, new projects, mergers and acquisitions, debt financing, the
energy component of costs, or through the activities of management, stakeholders,
competitors, foreign governments, or weather.
When financial prices change dramatically, it can increase costs, reduce revenues, or
otherwise adversely impact the profitability of an organization. Financial fluctuations
may make it more difficult to plan and budget, price goods and services, and allocate
capital.

There are three main sources of financial risk:

1. Financial risks arising from an organization’s exposure to changes in market prices, such
as interest rates, exchange rates, and commodity prices
2. Financial risks arising from the actions of, and transactions with, other organizations such
as vendors, customers, and counterparties in derivatives transactions
3. Financial risks resulting from internal actions or failures of the organization, particularly
 people, processes,and systems

What Is Financial Risk Management?

Financial risk management is a process to deal with the uncertainties resulting from
financial markets. It involves assessing the financial risks facing an organization and
developing management strategies consistent with internal priorities and policies.
Addressing financial risks proactively may provide an organization with a competitive
advantage. It also ensures that management, operational staff, stakeholders, and the board
of directors are in agreement on key issues of risk.
Managing financial risk necessitates making organizational decisions about risks that
are acceptable versus those that are not. The passive strategy of taking no action is the
acceptance of all risks by default.
Organizations manage financial risk using a variety of strategies and products. It is
important to understand how these products and strategies work to reduce risk within the
context of the organization’s risk tolerance and objectives.
Strategies for risk management often involve derivatives. Derivatives are traded
widely among financial institutions and on organized exchanges. The value of derivatives
contracts, such as futures, forwards, options, and swaps, is derived from the price of the
underlying asset. Derivatives trade on interest rates, exchange rates, commodities, equity
and fixed income securities, credit, and even weather.
The products and strategies used by market participants to manage financial risk are the
same ones used by speculators to increase leverage and risk. Although it can be argued that
widespread use of derivatives increases risk, the existence of derivatives enables those who
wish to reduce risk to pass it along to those who seek risk and its associated opportunities.
The ability to estimate the likelihood of a financial loss is highly desirable. However,
standard theories of probability often fail in the analysis of financial markets. Risks usually
do not exist in isolation, and the interactions of several exposures may have to be considered
in developing an understanding of how financial risk arises. Sometimes, these interactions
are difficult to forecast, since they ultimately depend on human behavior. The process of
financial risk management is an ongoing one. Strategies need to be implemented and
refined as the market and requirements change. Refinements may reflect changing
expectations about market rates, changes to the business environment, or changing
international political conditions, for example. In general, the process can be summarized
as follows:
Identification and Evaluation of Risk

• Identify and prioritize key financial risks.

• Determine an appropriate level of risk tolerance.

• Implement risk management strategy in accordance with policy.

• Measure, report, monitor, and refine as needed.

Diversification
For many years, the riskiness of an asset was assessed based only on the variability of its
returns. In contrast, modern portfolio theory considers not only an asset’s riskiness, but
also its contribution to the overall riskness of the portfolio to which it is added.
Organizations may have an opportunity to reduce risk as a result of risk diversification.
In portfolio management terms, the addition of individual components to a portfolio
provides opportunities for diversification, within limits. A diversified portfolio contains
assets whose returns are dissimilar, in other words, weakly or negatively correlated with
one another. It is useful to think of the exposures of an organization as a portfolio and
consider the impact of changes or additions on the potential risk of the total.
Diversification is an important tool in managing financial risks. Diversification
among counterparties may reduce the risk that unexpected events adversely impact the
organization through defaults. Diversification among investment assets reduces the
magnitude of loss if one issuer fails. Diversification of customers, suppliers, and
financing sources reduces the possibility that an organization will have its business
adversely affected by changes outside management’s control. Although the risk of loss
still exists, diversification may reduce the opportunity for large adverse outcomes.

Hedging and Correlation

Hedging is the business of seeking assets or events that off- set, or have weak or negative
correlation to, an organization’s financial exposures.
Correlation measures the tendency of two assets to move, or not move, together. This
tendency is quantified by a coefficient between –1 and +1. Correlation of +1.0 signifies per
fect positive correlation and means that two assets can be expected to move together.
Correlation of –1.0 signifies perfect negative correlation, which means that two assets can
be expected to move together but in opposite directions.
The concept of negative correlation is central to hedging and risk management. Risk
management involves pairing a financial exposure with an instrument or strategy that is
negatively correlated to the exposure.
A long futures contract used to hedge a short underlying expo- sure employs the concept of
negative correlation. If the price of the underlying (short) exposure begins to rise, the value
of the (long) futures contract will also increase, offsetting some or all of the losses that
occur. The extent of the protection offered by the hedge depends on the degree of negative
cor- relation between the two.
Decisions in Financial Management
There are four main financial decisions:-
1. Capital Budgeting or Long term Investment Decision
2. Capital Structure or Financing Decision
3. Dividend Decision
4. Working Capital Management Decision.

1. Investment Decision:

A financial decision which is concerned with how the firm’s funds are invested in different
assets is known as investment decision. Investment decision can be long-term or short-term.

A long term investment decision is called capital budgeting decisions which involve huge
amounts of long term investments and are irreversible except at a huge cost. Short-term
investment decisions are called working capital decisions, which affect day to day working of a
business. It includes the decisions about the levels of cash, inventory and receivables.

A bad capital budgeting decision normally has the capacity to severely damage the financial
fortune of a business.

A bad working capital decision affects the liquidity and profitability of a business.

Factors Affecting Investment Decisions / Capital Budgeting Decisions:

1. Cash flows of the project- The series of cash receipts and payments over the life of an
investment proposal should be considered and analyzed for selecting the best proposal.

2. Rate of return- The expected returns from each proposal and risk involved in them should be
taken into account to select the best proposal.

3. Investment criteria involved- The various investment proposals are evaluated on the basis of
capital budgeting techniques. Which involve calculation regarding investment amount, interest
rate, cash flows, rate of return etc. It is to be considered which technique to use for evaluation of
projects.
2. Financing Decision:

A financial decision which is concerned with the amount of finance to be raised from various
long term sources of funds like, equity shares, preference shares, debentures, bank loans etc. Is
called financing decision. In other words, it is a decision on the ‘capital structure’ of the
company.

Capital Structure Owner’s Fund + Borrowed Fund

Financial Risk:

The risk of default on payment of periodical interest and repayment of capital on ‘borrowed
funds’ is called financial risk.

Factors Affecting Financing Decision:

1. Cost- The cost of raising funds from different sources is different. The cost of equity is more
than the cost of debts. The cheapest source should be selected prudently.

2. Risk- The risk associated with different sources is different. More risk is associated with
borrowed funds as compared to owner’s fund as interest is paid on it and it is also repaid after a
fixed period of time or on expiry of its tenure.

3. Flotation cost- The cost involved in issuing securities such as broker’s commission,
underwriter’s fees, expenses on prospectus etc. Is called flotation cost. Higher the flotation cost,
less attractive is the source of finance.

4. Cash flow position of the business- In case the cash flow position of a company is good
enough then it can easily use borrowed funds.

5. Control considerations- In case the existing shareholders want to retain the complete control of
business then finance can be raised through borrowed funds but when they are ready for dilution
of control over business, equity shares can be used for raising finance.

6. State of capital markets- During boom period, finance can easily be raised by issuing shares
but during depression period, raising finance by means of debt is easy.

3. Dividend Decision:

A financial decision which is concerned with deciding how much of the profit earned by the
company should be distributed among shareholders (dividend) and how much should be retained
for the future contingencies (retained earnings) is called dividend decision.
Dividend refers to that part of the profit which is distributed to shareholders. The decision
regarding dividend should be taken keeping in view the overall objective of maximizing
shareholder s wealth.

Factors affecting Dividend Decision:

1. Earnings- Company having high and stable earning could declare high rate of dividends as
dividends are paid out of current and past earnings.

2. Stability of dividends- Companies generally follow the policy of stable dividend. The dividend
per share is not altered in case earning changes by small proportion or increase in earnings is
temporary in nature.

3. Growth prospects- In case there are growth prospects for the company in the near future then,
it will retain its earnings and thus, no or less dividend will be declared.

4. Cash flow positions- Dividends involve an outflow of cash and thus, availability of adequate
cash is foremost requirement for declaration of dividends.

5. Preference of shareholders- While deciding about dividend the preference of shareholders is

also taken into account. In case shareholders desire for dividend then company may go for
declaring the same. In such case the amount of dividend depends upon the degree of expectations
of shareholders.

6. Taxation policy- A company is required to pay tax on dividend declared by it. If tax on
dividend is higher, company will prefer to pay less by way of dividends whereas if tax rates are
lower, then more dividends can be declared by the company.